Berkshire Hathaway's Charlie Munger-backed external fund manager Li Lu doesn't beat around the bush when he says, "The biggest investment risk is not price volatility, but whether you will suffer a permanent loss of capital." So it seems that smart money knows that debt, which is generally involved in bankruptcies, is a very important factor when assessing a company's risk. We notice that Torrent power limited (NSE: TORNTPOWER) has debt on its balance sheet. But should shareholders be concerned about the use of debt?
When is debt a problem?
Generally speaking, debt only becomes a real problem when a business cannot easily pay it off, either by raising capital or with its own cash flow. In the worst case, a business can go bankrupt if it cannot pay its creditors. While that's not all that common, we often see indebted companies permanently diluting shareholders because lenders force them to raise capital at a high price. That said, the most common situation is when a company manages its debt reasonably well, and for its own benefit. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
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How much debt does Torrent Power have?
The image below, which you can click for more details, shows that Torrent Power was โน 78.2 billion in debt at the end of March 2021, a reduction of โน 89.2 billion in one year. On the other hand, you have $ 5.34 billion in cash, which generates a net debt of around $ 72.9 billion.
A look at the responsibilities of Torrent Power
According to the latest reported balance sheet, Torrent Power had liabilities of Rs 48.1 billion maturing in 12 months and liabilities of Rs 85.1 billion maturing after 12 months. On the other hand, it had cash worth Rs 5.34 billion and accounts receivable worth Rs 31.4 billion due within one year. Therefore, it has liabilities totaling โน 96.5 billion more than its cash and short-term accounts receivable combined.
While this may sound like a lot, it's not that bad as Torrent Power has a market capitalization of โน 229.5b, so you could probably strengthen your balance sheet by raising capital if necessary. However, it is still worth taking a close look at your ability to repay the debt.
We use two main reasons for reporting debt levels relative to earnings. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how many times your earnings before interest and taxes (EBIT) cover your interest expense (or your coverage of interests for short). In this way, we consider both the absolute amount of the debt and the interest rates paid on it.
Torrent Power's net debt stands at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense only 3.1 times last year. While these numbers don't alarm us, it's worth noting that the company's cost of debt is having a real impact. Shareholders should know that Torrent Power's EBIT was down 20% last year. If that earnings trend continues, paying off your debt will be as easy as taking cats on a roller coaster. There is no doubt that we are learning more about debt on the balance sheet. But it's future earnings, more than anything else, that will determine Torrent Power's ability to maintain a healthy balance sheet going forward. So if you want to see what the pros think, you can find this free report on analyst earnings forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper earnings; you need hard cash. Therefore, it is clear that we must analyze whether that EBIT is generating the corresponding free cash flow. During the last three years, Torrent Power posted a free cash flow of 70% of its EBIT, which is roughly normal given that the free cash flow excludes interest and taxes. This cash means you can reduce your debt whenever you want.
Our sight
Torrent Power's struggle to grow its EBIT made us question the strength of its balance sheet, but the other data points we considered were relatively redeemed. In particular, its conversion from EBIT to free cash flow was invigorating. We must also bear in mind that companies in the electrical service industry such as Torrent Power usually use debt without problems. We think Torrent Power's debt makes it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, as leverage can boost equity returns, but it's something to be aware of. When looking at debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides on the balance sheet, far from it. For example, Torrent Power has 2 warning signs We think you should consider.
When all is said and done, it is sometimes easier to focus on companies that don't even need debt. Readers can access list of growth stocks with zero net debt 100% free, now.
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